Tips For Reflecting Your Business Value In Your Buy-Sell Plan

2/09/2015 @ 9:41AM

Here’s an email a business owner might send to their advisor:

Jill and I have finally had our business valued and have come to an agreement on how we want to handle the business if one of us were to leave someday. Now what?

Emails like these represent a crucial point in business exit planning. A point at which decisions made will have long-reaching consequences. It is not enough for the owners to agree on a value. They must have a buy-sell agreement in place reflecting that value. And it’s not enough for the owners to agree on how they would buy and sell their ownership interests but have no agreement on how to value the business.

For an exit plan to work, there needs to be a buy-sell agreement that reflects both:

• The valuation of the business
• And the terms of an eventual sale

Reflecting the value

In reviewing buy-sell agreements between owners of a business, I commonly see six methods for reflecting the value of the business in the agreement. These methods are not mutually exclusive, and sometimes, one value may be a back-up for another valuation method.

1. Book value – Take assets minus liabilities, and declare the result to be the value of the business. Simple, but is it really reflective of the business’s on-going value? An exiting owner is effectively agreeing to take a liquidation value, ignoring the goodwill and earnings value of the business. And it may not reflect adjustments for depreciation, inventory, fair market value of assets and diluted value. Simple does not mean accurate.
2. Stated value – This approach states a specific value in the buy-sell agreement. It assumes the business has been valued, the owners agree on the value, and they are willing to be bound by the stated amount. This approach will work fine … for a while. The question is, what happens if and when the value of the business changes? Do the owners want to be bound by a value determined five years ago?
3. Appraised value – A buy-sell agreement might state that the value will be determined at the time of a sale by an independent appraisal. Sometimes the agreement requires both the buying and selling parties to acquire an appraisal with a third appraisal used as a tie-breaker. An appraisal assures a timely and independent view of the value of the business at sale. The issue is expense. Does it make sense for a $1 million business to write out a five figure check to appraisers every time a partner exits the business?
4. Formula value – A common approach, particularly with professional practices, is to state a formula by which the business interest will be valued at the time of exit of an owner. An example might be the average of the last three years of earnings, plus the adjusted book value. This approach generally simplifies the process but can sometimes lead to values that aren’t realistic. Consider two businesses with the same “average of the last three years of earning” clause. Even though one has increasing earnings over those three years and the other had decreasing earnings, the formula doesn’t distinguish between the two.
5. Value determined by life insurance – Occasionally I see a buy-sell agreement where the business value is directly tied to the death benefit of life insurance that has been purchased to fund the agreement. Although it is often appropriate to fund buy-sell agreements with life insurance – and helpful to require the insurance to be used to execute the agreement – it doesn’t make sense to use the death benefit for the valuation. The insurance may independently increase or decrease in value, and in a worst case scenario, it may lapse.
6. Mutual consent – All too often, a buy-sell agreement is specific on terms except it’s missing the valuation component. Such an agreement typically states that the parties will mutually agree on a value at the time of exit by a partner. Even though the partners may have a perfectly cordial relationship, the advisability of this approach is suspect. Time and finances can change relationships. And outside parties can alter the landscape as well. Spouses, trustees and creditors may affect how a buying or selling party views the value of the business.
   
   

Which value to use

Let’s fast forward that email from the top. Again, this is business owner to advisor:

Thanks for the primer on valuation techniques. But which approach should we use in our buy-sell agreement?

While “it depends” is the easy answer, I have a better suggestion. Start with the following principles, and then adjust as needed for your specific situation.

• Generally avoid using book value, value determined by life insurance and mutual consent provisions. There certainly are exceptions, but the default should be to first question these approaches.
• You can start by considering a stated value provision. The provision should require that an appraisal be used if the stated value hasn’t been updated recently. For example, the agreement might state the business value is X, but if that value has not been amended in the buy-sell agreement in the last three years, an appraisal will be required.
• If you decide to use a formula approach, make sure the formula reflects the realities of your business and industry.
• If an owner’s business interest is expected to be substantial (say, worth more than $5 million), it may be useful to require an appraisal as part of the buy-sell agreement. The benefit on an appraisal may exceed the cost.
• Whatever direction you’re leaning, don’t go it alone. Get your advisor team together, and leverage their expertise to come up with an approach that works for you and your partners.

For additional information regarding Florida business sales, acquisitions and valuations, please contact Eric J. Gall at Eric@EdisonAvenue.com or 239.738.6227. Also, visit our Edison Avenue website at www.EdisonAvenue.com or my personal website at www.BuySellFLbiz.com.